In 1983, the CBOE introduced options on the S&P 100 index—the first cash-settled index option. Instead of delivering 100 different stocks when exercised, the option simply paid out the difference in cash. This innovation opened the door to portfolio hedging strategies.
This chapter covers index options and multi-leg strategies that bet on volatility or stability rather than direction. Focus on understanding concepts rather than memorizing calculations.
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Section 1: Index Options
Popular Index Options
- SPX: S&P 500 Index (500 largest companies)
- OEX: S&P 100 Index (100 stocks from S&P 500)
- DJX: Dow Jones Industrial Average (30 stocks)
Key Characteristics
- Cash settlement: No stock delivery; pay the in-the-money amount
- Multiplier: $100 (same as equity options)
- No adjustment: Splits/dividends don't affect index options
- European style: Most index options (except OEX)
Beta and Hedging
Beta measures volatility relative to the market. A beta of 1 means the portfolio moves with the market. Beta of 2 means twice as volatile.
- Can hedge systematic risk (market risk)
- Cannot hedge nonsystematic risk (company-specific risk)
- Higher beta = need more contracts to hedge
ETF Options
ETF options differ from index options: they're American style and settle in ETF shares (not cash). They can also hedge systematic risk.
| Index Option | ETF Option | |
|---|---|---|
| Settlement | Cash | Shares |
| Style | Mostly European | American |
| When Settled | a.m. | p.m. |
| Topic | Key Details |
|---|---|
| Index options | Cash settlement; European style; hedge systematic risk |
| ETF options | Share settlement; American style |
| Beta | Volatility measure; affects number of contracts needed |
Section 2: VIX, Interest Rate Index, and Currency Options
VIX (Volatility Index) Options
The VIX is the "fear gauge"—it measures expected stock price volatility over 30 days. VIX is negatively correlated to stock prices.
Test Tip: If you think markets will RISE, buy VIX PUTS (fear falls). If you think markets will FALL, buy VIX CALLS (fear rises).
Interest Rate Index Options (TYX)
The TYX tracks 30-Year Treasury Bond Yield. Key point: premiums move with interest rates, not bond prices.
- Long Treasuries + rising rates = buy TYX calls to hedge
- Short Treasuries + falling rates = buy TYX puts to hedge
Foreign Currency Options
Currency options trade on the Philadelphia Stock Exchange (PHLX). They're European style and settle in cash.
Exporters hedge against currency decline with long PUTS
Importers hedge against currency rise with long CALLS
| Option Type | Key Characteristic |
|---|---|
| VIX | Negatively correlated to stocks; "fear gauge" |
| TYX | Tracks yield movements; European style |
| Currency | PHLX; European style; Export puts/Import calls |
Section 3: Straddles and Combinations
Straddles and combinations bet on volatility or stability rather than direction.
Long Straddle = Long Call + Long Put
Same strike price and expiration. The investor wants volatility—profits if market moves significantly in either direction. Pays double premium.
Short Straddle = Short Call + Short Put
Same strike price and expiration. The investor wants stability—profits if market stays flat. Receives double premium.
| Strategy | Components | Market View |
|---|---|---|
| Long Straddle | Long Call + Long Put | Expects big move (volatile) |
| Short Straddle | Short Call + Short Put | Expects stability (flat) |
Combinations (Strangles)
Same as straddles but with different strike prices or expirations. A "strangle" typically uses out-of-the-money options (lower premium, needs bigger move).
| Strategy | Key Characteristic |
|---|---|
| Long Straddle | Buy volatility; same strike/expiration |
| Short Straddle | Sell volatility; same strike/expiration |
| Combination | Different strike or expiration |
Section 4: Spreads
Spreads involve buying one option and selling another of the same type. They offer limited-gain/limited-loss wagers that are moderately bullish or bearish.
Types of Spreads
- Call spread: Buy a call + sell a call
- Put spread: Buy a put + sell a put
Debit vs. Credit Spreads
| Spread Type | Position | Market Bias |
|---|---|---|
| Debit Call | Net buyer of calls | Bullish |
| Credit Call | Net seller of calls | Bearish |
| Debit Put | Net buyer of puts | Bearish |
| Credit Put | Net seller of puts | Bullish |
Spread Classifications
- Vertical (Price): Different strike prices, same expiration
- Horizontal (Calendar/Time): Same strike, different expirations
- Diagonal: Different strikes AND expirations
| Topic | Key Details |
|---|---|
| Call spread | Buy call + sell call |
| Put spread | Buy put + sell put |
| Debit = Bull for calls | Credit = Bull for puts |
| Vertical | Different strikes; Horizontal = different expirations |
Chapter 10 Key Terms Glossary
| Term | Definition |
|---|---|
| Index option | Option on stock basket; cash settlement |
| Cash settlement | Pay in-the-money amount; no stock delivery |
| Beta | Volatility relative to market |
| Systematic risk | Market risk; can hedge with index options |
| ETF option | Option on ETF; settles in shares |
| VIX | Volatility Index; "fear gauge" |
| TYX | 30-Year Treasury yield index |
| Long straddle | Long call + put; wants volatility |
| Short straddle | Short call + put; wants stability |
| Strangle | Combination with different strikes |
| Call spread | Buy call + sell call |
| Put spread | Buy put + sell put |
| Debit spread | Net cost; buyer of spread |
| Credit spread | Net credit; seller of spread |
| Vertical spread | Different strikes; same expiration |
| Horizontal spread | Same strike; different expirations |
Chapter 10 completes your options knowledge for the Series 7 exam. These advanced strategies build on the fundamentals from Chapter 9.